Investment Decisions 04/22/08 Ch. 5

2 Pick Industries and Companies Each Group Picks Industry First and Second Choice Industries unique to a group Groups then pick companies Must trade on major exchange Should be US company Exception to US company, ADRs Substitutes after initial selection One week

3 Investment Decision We will examine three items in this chapter Incremental Cash Flow Decision Models Where good projects come from Incremental Cash Flow...the basis of the project Decision Models – Discounted Cash Flow Picking good projects – luck or talent?

4 Incremental Cash Flow It is only the net new dollars of a project that are important Sunk Costs do count in decision… Not in the cash flow Could provide valuable information on cash flow Example, market study before product launch Erosion Costs Story of pudding pops… When are erosion costs not erosion costs? Allocated Costs Only the additional costs should be considered Use accounting income format with adjustments for the Incremental Cash Flow

5 Incremental Cash Flow Three main parts 1. Invested Capital 2. Operating Cash Flow we think of these as the income stream from the project over the life of the project 3. Working capital we think of these costs as the support of the project, for example, inventory

6 What is the appropriate decision rule? Objective vs. Subjective Like to quantify all the important issues and data Like to use experience Solution is consistent with firm value maximization Works in a variety of settings

7 Some Choices that fail… Accounting based decisions, Return on Capital Earnings are not cash Possible to manipulate the earnings Economic Value Added Again relies on accounting information to find the Return on Equity Is consistent with increasing firm value

8 Net Present Value The preferred discount model as it includes all future cash flow discounted back to present at the “appropriate” risk-related rate NPV profile provides the NPV at various discount rates Is sensitive to the incremental cash flow estimates NPV formula…

9 Internal Rate of Return, IRR Alternative to NPV Finds the discount rate at the point where the NPV is zero then compares to hurdle rate Has some potential problems Multiple IRRs Assumes all intermediate cash flow is reinvested at the IRR rate Can lead to some wrong choices when comparing projects

10 Modified Internal Rate of Return Changes the reinvestment assumption of IRR from the IRR rate to the hurdle rate Takes all positive cash flow to the end of project at the hurdle rate Finds the future value of the positive cash flow at end of project Finds the discount rate that equates the FV of the benefits with the PV of the costs Is this better than IRR?

11 Where do good projects come from? First and foremost…good ideas Good ideas Smart People Innovative People Risk Takers Luck Others? Do all good projects work out?

12 How to exploit good projects Economies of Scale (large volume) Cost Advantages (overseas labor access) Capital Requirements (Off shore oil platforms) Product Differentiation (reputation or recognized products, Coca-Cola) Access to Distribution Channels (Microbrews) Legal and Government Barriers (patents and licensing requirements)

13 Problems from Chapter 5 9 (Estimate NPV and IRR) 10 (Estimate MIRR) 11 (Mutually Exclusive) – Also draw the NPV profile of the two projects. What does this tell you? 12 (IRR puzzle) 16 (NPV and IRR) 17 (Changing discount rates) 19 (NPV and IRR)